Oil Shocks: How Destabilizing are they?

Munich Personal RePEc Archive

Oil Shocks: How Destabilizing are they?

Bhattacharya, Jyotirmoy

Indian Institute of Management Kozhikode

2008

Online at

https://mpra.ub.uni-muenchen.de/12116/

JYOTIRMOY BHATTACHARYA

Abstract. This note examines Prabhat Patnaik’s argument that the contemporary international financial system crucially requires the stability of oil prices in terms of the dollar. By comparing the macroeconomic impact of recent oil shocks to those of the 1970s, it argues that sharp changes in the dollar price of oil need not necessarily lead to instability.

One of the most striking conclusions reached in Prof. Prabhat Pat-naik’s recent book The Value of Money is that the world monetary system is still de facto a commodity money world, despite having bro-ken all de jure links to the world of commodities after the collapse of the Bretton Woods system (Patnaik, 2008, Chapter 19).

Prof. Patnaik’s argument proceeds in two steps. The necessity of the value of money being stable in terms of commodities—established earlier in the book for a single capitalist economy—takes the form of the necessity of the ‘leading currency’ maintaining a stable value in terms of commodities when the analysis moves to the setting of a world with many capitalist economies.

A threat to this stability can come from two main sources— au-tonomous increases in the price of labour power and increases in the price of primary commodities. Prof. Patnaik considers the former to be unlikely in the present deflationary regime imposed by finance capi-tal. As for the latter, non-oil primary commodities do not pose a major threat to stability, most importantly because of their low share in the gross GDP of the advanced capitalist countries.

Thus, by elimination, the essential condition for the sustenance of the present world monetary regime with the dollar as the leading currency is the maintenance of a stable dollar price of oil—what Prof. Patnaik terms the oil-dollar standard—and it is in this sense that this regime is a de facto commodity money system.

This conclusion not only has far-reaching implications for the aca-demic understanding of the international monetary system, it also pro-vides a basis for an understanding of the recent tendencies of US im-perialism.

I am extremely grateful to Prof. Jayati Ghosh, Rohit, Prasenjit Bose and the par-ticipants at the 2008 IDEAS conference on ‘The Value of Money and Contemporary Capitalism’ for very helpful comments on an earlier version of this note.

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The converse of Prof. Patnaik’s argument is that periods in which the dollar price of oil rises would, ceteris paribus, be periods of in-stability of the world capitalist system. This suggests the possibility of empirically testing, as it were, Prof. Patnaik’s analysis of the con-temporary international monetary system by looking precisely at such periods when the dollar price of oil has been rising.

It is our purpose in the present note to set the grounds for such a test by reviewing the existing evidence on the response of advanced capitalist economies to oil price shocks.

We are aware that any attempt at empirical verification on these lines is subject to a number of difficulties. First, there is no way to directly control for the violation of the ceteris paribus clause. Given that we only have a handful of episodes of large oil price increases over a number of decades during which the economies under study have changed drastically, there is no way to mechanically filter out the effects of our failure to control for ‘other factors’. The best way forward seems to be to try to identify the most significant such factors for each episode and at least informally gauge the effect that they may have had.

The second difficulty in our exercise, common to all empirical macroe-conomics, is our inability to observe expectations. As Prof. Patnaik points out, temporary fluctuations in oil prices do not pose any threat to the oil-dollar standard. Only secular increases, or more importantly, increases perceived to be secular increases do. However, we feel that by not looking at all changes in oil prices but limiting ourselves to oil price ‘shocks’, i.e. significant and sustained increases in oil prices, we address this difficulty to some extent.

1. The Evidence

Following the stagflation of the 1970s, it had till recently been the general opinion among macroeconomists that oil price shocks pose a serious threat to the stability of the world economy, including the ad-vanced capitalist countries. As Hamilton pointed out in his pioneering study of the impact of oil price shocks on the US economy, Hamilton (1983): “All but one of the U.S. recessions since World War II have been preceded, typically with a lag of around three-fourths of a year, by a dramatic increase in the price of crude petroleum”.

Figure 1. US Oil Prices—West Texas Intermediate [Source: FRED (Federal Reserve Economic Data)]

a resolution either. Even if a mechanism could be found whereby high oil prices would be a cause of the US housing bubble bursting, the long lag between the price increase and the slowdown would still cast doubts on any simple mechanisms connecting oil price increases to economic instability.

Such doubts had already started being voiced during the 1990s based on research which showed an apparent break in the relationship be-tween oil prices and macroeconomic variables in the 1980s, with the relationship being much weaker in the later period. These observa-tions led to three broad quesobserva-tions. Was there really a weakening in the oil-macroeconomy relationship during the 1980s or was the apparent weakening a statistical artifact? If the relationship was weak during the 1980s, had it been strong even in the 1970s? If the relationship was strong during the 1970s and weak in the 80s and 90s, what had changed in between?

1.1. Oil shocks. Figure 1 plots the nominal US oil prices from 1970:1 to 2008:8.

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run up period 50% rise date max log change ($) max log change (real) O1 1973:3–1974:1 1974:1 104% 96% O2 1979:1–1980:2 1979:3 98% 85% O3 1999:1–2000:4 1999:3 91% 87% O4 2002:1–2007:3 2003:1 125% 110%

Table 1. Postwar Oil Shock Episodes. [Source: Blan-chard and Gal´ı (2008)]

O1 O2 O3 O4 AVG(1,2) AVG(3,4) Canada 4.7 1.8 2.2 0.5 3.3 1.4 Germany 0.1 2.6 1.1 -0.2 1.4 0.4 France 5.4 3.1 1.3 0.5 4.2 0.9 U.K. 10.2 4.3 0.0 0.5 7.3 0.3 Italy 7.7 5.6 1.0 -0.1 6.6 0.4 Japan 7.9 1.0 -1.7 0.9 4.4 -0.4 U.S. 4.9 4.0 1.7 -0.2 4.5 0.7 G7 4.8 1.9 0.3 0.0 3.3 0.2 Euro12 4.3 2.7 1.3 -0.5 3.5 0.4 OECD 4.9 1.8 0.1 -0.5 3.4 -0.2

Table 2. Oil Shock Episodes: Change in Inflation. [Source: Blanchard and Gal´ı (2008)]

O1 O2 O3 O4 AVG(1,2) AVG(3,4) Canada -8.3 -1.0 -1.5 3.2 -4.6 0.8 Germany -9.6 -3.5 1.3 -2.5 -6.6 -0.6 France -7.6 -4.4 0.6 1.2 -6.0 0.9 U.K. -16.4 -9.2 0.4 2.5 -12.8 1.4 Italy -8.6 0.4 3.0 -2.0 -4.1 0.5 Japan -16.1 -4.4 7.6 3.3 -10.3 5.4 U.S. -13.3 -11.8 -3.7 7.1 -12.5 1.7 G7 -12.6 -7.7 -0.2 3.9 -10.2 1.8 Euro12 -9.1 -2.9 1.0 -0.4 -6.0 0.3 OECD -11.2 -6.5 0.1 4.1 -8.9 2.1

Table 3. Oil Shock Episodes: Cumulative Change in GDP.[Source: Blanchard and Gal´ı (2008)]

more than four quarters”. Using this criteria they identify the episodes shown in Table 1.12

1_{Blanchard and Gal´ı conclude their analysis at 2007:3. But it is evident from}

figure 1 that O4 is still continuing.

2_{Blanchard and Gal´ı’s criteria does not identify the shock triggered by the first}

For the four episodes that they identify, Blanchard and Gal´ı calculate the change in inflation and GDP for the individual G7 countries as well as a few aggregates of advanced countries. These are shown in Tables 2 and 3. With a few exceptions both these tables show the pattern referred to above. In the 1970s, oil price shocks clearly lead to stagflation. In the 1990s and 2000s, the effect is much less, if not non-existent.

Starting with Hamilton (1983), attempts have been made to look at the same relationship using the entire time series of oil prices and macroeconomic aggregates rather than individual shock episodes. Mork (1989), Hooker (1996), Hamilton (1996) are important contributions to this literature. Once we move away from looking only at oil price in-creases clearly associated with political/military events in the Middle East, two problems need solving. First, to what extent can we con-sider oil price changes as being exogenous to macroeconomic fluctua-tions. Second, we have to account for the possibility that the effect of oil price increases and oil price decreases may not be symmetric. The answer to these questions have an important bearing when evaluating alternative theoretical explanations of the oil-price economy relation-ship, but none of the adjustments needed to account for them overturn the basic conclusions in the tables above—oil-price increases had a large impact on output and inflation in the 1970s, the effect is much less in the 1990s and 2000s. The challenge for theory is to account for both these facts simultaneously.

2. Recessions

2.1. Large impact on output. Any attempt to develop a theoretical understanding of the effect of oil price shocks on output and prices immediately comes up against the obstacle that simple models of the macroeconomy predict changes in output that are too small. While we would expect an increase in the price of oil to reduce the demand for oil and for directly or indirectly energy-intensive commodities like automobiles, it is not immediately clear why an oil price shock should create a downturn as sharp as those of the 1970s. This is a problem for both demand-side and supply-side theories.

The simplest supply-side mode is competitive market-clearing neo-classical model. In a model of that sort, output is most easily modelled as being produced jointly by labour, capital and energy by a production function:

Y =F(N, K, E) (1)

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For the U.S. economy a reasonable value for this share would be 4%, which would imply an output reduction of 0.4% for every 10% decrease in energy use, much smaller than what was observed during the 1970s. A naive demand-side argument which sees an oil price increase as a tax which reduces the disposable income of oil buyers and increases the income of oil sellers would fare no better. Even if we assume that oil sellers do not consume any domestic goods out of their extra income, the relative income fall of oil buyers would at most be proportional to the share of oil in consumption expenditures, and that number would once again be too small to explain the recessions of the 1970s.

Given this, attempts have been made to explain the recessionary ef-fects by bringing in secondary factors which may magnify the initial impact of oil price increases. Rothemberg and Woodford (1996) bring in imperfect competition and mark-up pricing, Finn (2000) introduces complementarity between energy and capital and variable capital util-isation and Hamilton (1988) introduces frictional employment arising out of the need to move labour out of industries which are directly or indirectly energy intensive (such as automobiles) to other indus-tries. Apart from limited empirical support, a major problem for all these models is their inability to explain the weakening of the oil-price macroeconomic relationship in the last two decades.

2.2. Monetary policy and the bargaining power of workers.

Given these difficulties in explaining the stagflation of the 1970s on the basis of purely private sector responses, one strand of literature starting with Bernanke et al. (1997) attributes the recession to incorrect mone-tary policy on the part of the Fed. Working in a vector auto-regression framework, Bernanke et al. (1997) tried to simulate the effects of a monetary policy that did not respond to oil price shocks and found that the reduction of output was lesser in their hypothetical regime. While the exact results of their analysis have been questioned on sta-tistical grounds by Hamilton and Herrera (2004), it seems reasonable to assume that at least a part of the downturn of the 1970s must be at-tributed to recessionary monetary policies of that period. This would fit into a picture of an attempt to defend the oil-dollar standard by squeezing the real claims of the working class. But then, the question that follows is why such recessionary policies were not needed during later oil shocks?

wage-price spiral. The later oil shocks were different both due to prior experience as well as due to the fact that in these later episodes there was a gradual increases in oil prices rather than a more abrupt jump. The last shock was also widely believed to have been caused by spec-ulation. All of these might have led to a perception of the shocks as being transitory and hence might not have triggered off a wage-price spiral.

While there may be an element of truth in this argument based on ex-pectations, it cannot negate the fact that the cumulative changes in oil prices were roughly comparable in the earlier and later episode. There-fore we would have expected a wage-price spiral to have been triggered off ultimately. The fact that it was not must therefore be attributed, in a conflicting-claims framework, to the flexibility of the claims of some strata. Two possible explanations stand out. One, a squeeze in the claims of domestic workers made easier by de-unionization and a re-duction in the rights of workers in general. Two, a squeeze in the claim of foreign workers mediated through cheaper imports. The fact that one or both of these leads to a muting of the destabilizing effect of oil shocks is certainly not a cause for celebration, since this muting comes at the cost of growing inequality. However, such muting does increase the resilience of the world monetary system based on the dollar. And we expect that this muting would become easier as a declining energy intensity of output makes the required squeeze in real wages smaller over time.

3. Conclusion

The response of contemporary capitalist economies to oil price shocks has changed. Why, can only guess, and maybe the next oil shock will prove all predictions of fundamental change wrong. But what we do see is that at least in certain conjunctures large oil price increase do not automatically lead to a crisis for the system.

Does this demand a change in the analysis of the world monetary system presented in Prof. Patnaik’s book? In essence, not at all. The fundamental impossibility of explaining the value of money through supply-and-demand and even the need for the leading currency of the time to maintain a stable value vis-a-vis commodities are conclusions that stand independently of the importance or otherwise of oil.

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References

Bernanke, B., M. Gertler, and M. Watson (1997): “System-atic Monetary Policy and the Effects of Oil Price Shocks,” Brooking Papers on Economic Activity 1.

Blanchard, O. and J. Gal´ı(2008): “The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so different from the 1970s,” Unpublished working paper.

Finn, M. G. (2000): “Perfect Competition and the Effects of Energy Price Increases on Economic Activity,”Journal of Money, Credit and Banking, 32, 400–416.

Hamilton, J. D. (1983): “Oil and the Macroeconomy since World War II,” Journal of Political Economy, 91, 228–248.

——— (1988): “A Neoclassical Model of Unemployment and the Busi-ness Cycle,” Journal of Political Economy, 593–617.

——— (1996): “This is what happened to the oil price-macroeconomy relationship,”Journal of Monetary Economics, 38, 215–220.

Hamilton, J. D. and A. Herrera (2004): “Oil Shocks and Ag-gregate Macroeconomic Behavior: The Role of Monetary Policy.”

Journal of Money, Credit & Banking, 36, 265–287.

Hooker, M. A. (1996): “What happened to the oil price-macroeconomy relationship?” Journal of Monetary Economics, 38, 195–213.

Mork, K. (1989): “Oil and the Macroeconomy When Prices Go Up and Down: An Extension of Hamilton’s Results,”Journal of Political Economy, 97, 740.

Patnaik, P. (2008): The Value of Money, Tulika Books.

Rothemberg, J. J. and M. Woodford (1996): “Imperfect Com-petition and the Effects of Energy Price Increases on Economic Ac-tivity,” Journal of Money, Credit & Banking, 28, 549–577.

Indian Institute of Management Kozhikode